BANKING CRISIS:With lavish bonuses and rewards quickly spent by Wall Street brokers in times of plenty, what happens when it all goes wrong?
CALIFORNIA LAWYER Charlie Munger, number 239 on the Forbes' list of the 400 richest Americans, has the distinction of having invested alongside Warren Buffet, the world's richest man, for nearly 50 years. As a result, Munger (84) owns at least two things of particular value: 15,000 shares of Berkshire Hathaway stock (worth €1.3 billion these days) and an uncommon sense of wisdom about human nature.
On the rare occasions when Munger has been profiled, he is described in an avuncular, Benjamin Franklin kind of way, which is particularly apt because both men are partial to aphorisms. Franklin's were collected in Poor Richard's Almanack, around 1750, and Munger's have been collected in Poor Charlie's Almanack, in 2005.
Both Franklin's and Munger's insights into what motivates behaviour in the business world are relevant to an examination of how the way Wall Street bankers and traders are paid has helped exacerbate the world's current financial crisis.
Franklin advised in elegant and spare prose: "If you would persuade, appeal to interest and not to reason." Munger elaborated on Franklin's thesis, based on an additional 250 years of empirical evidence.
"Another generalised consequence of incentive-caused bias is that man tends to 'game' all human systems, often displaying great ingenuity in wrongly serving himself at the expense of others," he observed.
"Anti-gaming features, therefore, constitute a huge and necessary part of almost all system design."
Bankers and traders are paid based on their short-term revenue production. The more revenue they bring to their firms, the more they are paid in their annual bonus and the more power they amass.
The bonuses for senior bankers and traders can easily run into the millions of dollars. For top performers, the annual compensation can be $10 million (€6.4 million), or more.
At the end of each fiscal year, Wall Street firms go through an elaborate process of requiring bankers to list all their transactions and the revenue associated with them. Not surprisingly, double-counting occurs, as nothing is truer on Wall Street than the old adage: "Success has many fathers and failure is an orphan."
These self-evaluations are then mixed into a cauldron of peer-reviews, internal politics and at least one very important external market survey - known in the industry as the McLagan Report (some Wall Streeters believe it facilitates cartel-like behavior) - and by the first quarter of the new fiscal year, at least half of the revenue taken in by Wall Street firms is then doled out in the form of bonuses, converted rapidly into Ferraris, Net-Jet subscriptions and Park Avenue Co-ops.
The money is never heard of again. The insidious process of Wall Street compensation then repeats itself.
Should there be a ticking time bomb contained in the previous year's activities - say, too big an inventory of illiquid mortgage securities on the balance sheet or too large a "bridge" loan that can't be syndicated - the men and women responsible for manufacturing them have long consumed their excessive compensation.
Making matters worse, Wall Street no longer has any mechanism in place to hold its bankers and traders accountable for their actions.
This was not always the case.
In fact, for most of Wall Street's 216-year history, when investment banks were small, private affairs, partners were held accountable for their actions through the genius of the collective liability clause in their partnership agreements.
When things went well, the partners shared in the abundant profits and quickly turned them into the requisite Fifth Avenue mansions and priceless art collections.
And if someone, somewhere, messed up, then the pain would be meted out ratably and effectively through a mechanism well understood by all partners: their bank accounts.
As one telling example, consider how the partners of Lazard Frères & Co, the illustrious and once-secretive investment bank, suffered in the early 1930s from the rogue behavior of a foreign-exchange trader in the firm's Brussels office.
In May 1931, with financial trouble brewing globally from the Gordian knot of the US and German Depressions, chronic budget deficits in the UK, the failure of the Creditanstalt (Austria's largest private bank) and the overvaluation of the pound versus the dollar, calamity struck Lazard well beyond the £40,000 that the Creditanstalt owed the firm and that appeared would not be repaid.
On his own authority, this lone trader had made massively bad bets against the French franc and had covered them up by issuing unsecured promissory notes across Europe in the name of Lazard Brothers, the London partnership.
He also kept two sets of books as an added deceitful twist. When the promissory notes were not paid as they became due, the plot began to unravel.
When the magnitude of the devastating capital loss became known - equal to £5.85 million, nearly twice Lazard Brothers' stated capital at the time - the trader pulled out a gun and shot himself. He was found dead underneath his desk, in a pool of blood. His suicide note read: "Tomorrow, the Lazard House will go down." A massive run on the bank loomed.
That did not happen, of course. That August Bank of England orchestrated a secret, rapid-fire bailout of the firm over the weekend.
Lazard Brothers was one of the UK's prized Accepting Houses; the Bank of England could not let Lazard fail.
In a series of furtive meetings held in mansions across London, the Bank fashioned a rescue whereby it lent £3 million to S Pearson & Son, the UK industrial conglomerate, which in turn lent the money at a high rate of interest to Lazard and took an 80 per cent equity stake in the London firm.
Another £1.5 million came in the form of a tax refund from Inland Revenue and the final £1 million came from the capital accounts of the two senior Lazard partners in Paris, Andre Meyer and Pierre David-Weill.
The capital infusion was sufficient to allow the recapitalised Lazard to open for business on Monday morning. The firm survived but at the cost of nearly wiping out the capital of its founders. Pearson, the owner of the Financial Times and 50 per cent of The Economist, held its equity stake in Lazard until 1999.
Explains Michel David-Weill, Pierre's son and Lazard's longtime patriarch: "For a long time Andre Meyer and my father had a negative capital (balance). It lasted until 1938."
But this implicit accountability for Wall Street partners - contained in the liability clause of the partnership agreements - began to change for good in 1969 when Donaldson Lufkin & Jenrette, a small, research-oriented brokerage, became the first Wall Street firm to become a publicly traded company.
Along with its new shareholders, DLJ flushed its partnership agreement. And just like that, the firm's liabilities, once shouldered collectively by the partners, were shifted onto the shareholders.
And the brunt of the pain, should there be any, was borne especially by the non-employee shareholders, since they owned the stock without receiving any compensation from the firm.
While DLJ's public offering was considered radical at the time, it wasn't long before most other Wall Street firms got with the IPO program, among them, Merrill Lynch (1971), Bear Stearns (1985), Morgan Stanley (1986) and Goldman Sachs (1999).
Not only did the public offerings of the Wall Street firms provide them with much-needed capital, but they also were a clever way to promote the next generation of leaders while cashing out the founders. By the time Lazard went public in May 2005, the final substantive transformation of Wall Street from a clubby world of private partnerships to (supposedly) well-capitalised global giants was complete.
Gone for good was any semblance of accountability for the behavior of Wall Street's bankers and traders.
As Munger might observe, Wall Street has now completely gamed its compensation system to reward employees for what it most cares about - generating revenues - while eschewing all the "anti-gaming" features of the past that often, but not always - acted as a carburetor on selfish, ill-advised behavior.
But in the wake of the current global credit crisis - that seemingly culminated overnight in the meltdown of Bear Stearns during the Ides of March - the need to restore accountability to the Wall Street compensation system has never been more acute.
Sadly, none of the regulatory reform proposals being bandied about in Washington at the moment - whether from Hank Paulson, the Secretary of the Treasury, or from Congressman Barney Frank, chairman of the House Financial Services Committee - contain one word about reforming Wall Street's compensation system.
Unless a way can be found to encourage the boards of directors of Wall Street firms to voluntarily repair the broken system with some good, old-fashioned "anti-gaming" features, history will be destined to repeat itself.
Before we know it, Wall Street's masters of the universe will figure out a way to re-inflate the balloon until it explodes anew.
ABOUT THE AUTHOR:William D Cohan, a former Mergers and Acquisitions banker on Wall Street for 17 years, is the author of The Last Tycoons: The Secret History of Lazard Frères & Co(Doubleday, 2007). The book was named winner of the FT/Goldman Sachs 2007 Business Book of the Year Award.
